Secrets of Sand Hill Road

by Scott Kupor

  If, however, the board views the recapitalization as a fresh start for the business to try to execute on a stand-alone path, a MIP can actually create the wrong incentives. In such a case, the MIP could provide the management team (or whoever are the beneficiaries of the MIP) a short-term incentive to sell the company versus playing for the longer term. For example, if you as CEO could receive a $2 million payment through the MIP by selling the company in the short term, you might orient your time toward that path, even though you might stand to earn a lot more money if the company remains stand-alone and ultimately goes public five years hence. Perhaps you think the risk of that latter path is too great, such that less money now with certainty seems more attractive. Thus, you and the board should carefully consider what behavior you are trying to incent.

  The bottom line in these situations is to ensure that the company is set up for whatever appropriate path the board and the employee base are heading down. If we all agree to play for a home run, then maximizing the long-term equity incentives of everyone involved is the right play. If we are just viewing this new financing as a short-term bridge to an acquisition, the MIP may make more sense.

  Winding Down

  Sometimes, despite everyone’s best efforts, the CEO and the board just don’t see a viable path forward for the business, and there are no acquisition options. At this point, the only remaining path is to wind down the company.

  If you find yourself in this situation, there are a few important things to consider as an executive or director.

  First, depending on the number of employees that you have, you may need to consider something called the WARN Act. There are both state and federal WARN statutes: the federal law applies to companies with more than one hundred employees, whereas some states (including California) apply the rule to companies with only fifty employees. While WARN was originally intended to deal with mass layoffs, particularly in manufacturing companies, WARN is applicable to any company at those employee levels that is planning to shut down and therefore lay off all its employees. In these circumstances, WARN requires that you provide these employees sixty days’ notice of such a shutdown, and, in the event you fail to do so, a company can have liability for up to sixty days’ worth of wages for those employees. While the law is not completely settled here, it is unlikely that individual board members and executives would have personal liability (beyond the liability for the corporation) for WARN violations.

  There is an exception to WARN liability under what is called the “faltering company exception.” This gives a company more latitude around the sixty-day WARN notice requirement if the company is actively pursuing financing for the business and believes that providing notice would significantly jeopardize the likelihood of being able to obtain that financing. For example, if you were worried that providing the notice would cause all your engineers to leave the company, and this exodus of employees would dissuade a potential investor from injecting capital into the business, you may be able to utilize the faltering company exception. Doing so of course requires a legitimate capital-raising process that the company reasonably believes could result in an investment. So startups that find themselves in this situation will want to keep an active log reflecting all the financing outreach they are undergoing, and the board minutes should reflect all these activities appropriately.

  Another thing to consider in this situation is potential liability for employee wages and accrued vacation. The general rule here is that you cannot keep employees working beyond the point at which you can pay payroll—seems pretty straightforward. For example, if you have $100,000 in the company bank account and your daily payroll exceeds this amount, you cannot keep employees on the books, even if you still have two weeks before the next official payroll cycle and think you might be able to raise new capital before then. If you do so and fail to raise the money, officers and directors could have personal liability to pay these expenses. Note, this is different from potential WARN liability, which likely attaches to the corporation only; in direct employee wages, compensation may have to come directly out of the officers’ and directors’ own pockets.

  A second area of potential personal liability is accrued vacation. Let’s say your company has a two-week annual paid vacation policy. Employees accrue (or earn) this vacation as they work during the year—for example, if we are now halfway through the year, employees will have accrued one week’s worth of that vacation. That accrual has an economic cost to the company equal to the employees’ wages that they would otherwise get paid for that one week. Once this vacation is earned, it belongs to the employee and is now a liability of the company. This is why, for example, if you quit your job, in addition to your final paycheck, your employer will typically pay you an additional amount of money equal to your accrued vacation.

  In the shutdown context, accrued vacation therefore is another expense for which officers and directors can have personal liability. And this number can get pretty big if you are not keeping an eye on it. Some companies, for example, allow employees to carry over from one year to the next accrued vacation time that they may not have used in any given year. So an employee with long tenure who hasn’t been using all her vacation each year can have a sizable accrued vacation expense on the company’s books. To avoid this, many companies have a use-it-or-lose-it vacation policy, which wipes the vacation liability off the books at the end of each year, so that in any given year, no more than two weeks’ worth of vacation liability will be present.

  As a result of these potential liabilities, startups that find themselves in a potential wind-down situation will want to review these topics with the board regularly and ensure that they don’t accidentally find themselves on the losing end of both the company’s dissolving and former employees’ seeking personal liability for employment-related expenses. As we noted earlier in the book, this is another place where being diligent about documenting board meeting notes to reflect the board’s diligence can pay huge dividends.

  What happens to other expenses that the company may have taken on for which it doesn’t have the money to pay? For example, what about expenses owed to manufacturers who may be developing the product or to other outside contractors who are performing some work for the company? The good news—at least for the officers and directors—is that these entities are generally treated as unsecured trade creditors in a wind-down situation. This is a fancy way of saying that they are largely screwed. They need to line up along with anyone else who is owed money by the now-defunct company and see if there are any remaining scraps from which they can be paid.

  The one significant exception to this is when the company acts in bad faith with respect to these creditors. For example, if you know that a wind down is inevitable, but you still choose to enter into a new contract with a vendor knowing that there is no way to ever pay them, the vendor might have a claim that you acted in bad faith and therefore sue you for liability. These claims are pretty hard for them to ultimately win, but, as we talked about earlier in the Trados discussion, you don’t want to tempt fate here, nor do you want to spend a bunch of time and money fighting legal claims post–wind down.

  In addition to raising equity, many startups these days also raise some form of debt. We are not talking here about convertible debt that is most commonly used during seed financing rounds, but rather debt that comes from a commercial bank or a specialized debt provider. Most debt is cheaper than equity, mainly because it doesn’t involve issuing more shares (which we all hope in the startup case are ultimately worth a lot of money). As a result, many startups choose to supplement their equity raises with some amount of bank debt.

  Thus, in the wind-down context, we also need to think about debtors, different from how we think about the equity holders. That is because the equity holders know that they are the lowest on the repayment totem pole in the event of a wind down; they will generally get nothing and understand that as part of the original bargain they made wh
en they purchased the equity. Debt holders, however, are higher on the totem pole and thus are generally first in line to collect any remaining money a company may have. They are not only ahead of equity holders, but also ahead of the unsecured trade creditors we talked about before (who are themselves ahead of the equity holders).

  Importantly, though, the board does not owe fiduciary duties to the debt holders. Thus, even when the company is facing the situation where they might need to wind down, the board’s fiduciary duties still run only to the equity holders. In practice, though, boards will take extra care in these situations to maintain constant communication with the debt holders and try to make every effort to pay back at least part of the debt in connection with a wind down.

  CHAPTER 15

  Exit Stage Left (The Good Kind)

  If you just read chapter 14, you’re probably in need of a big breath of fresh air and positivity. Here it is on a silver platter, and it comes in the form of a successful realization of the entrepreneurial life cycle.

  Let’s fast-forward your startup to success and imagine that you are starting to think about exiting. This time, we are talking about good exits, as opposed to the not-so-exciting last-ditch acquisition alternatives we reviewed in the previous chapters.

  Venture-backed companies often exit either through an acquisition by another company or via an IPO. We are using the term “exit” somewhat euphemistically here in that, in the case of an IPO, the company itself is not exiting anything (in fact it’s entering a new chapter of its life as a public company), but oftentimes the VCs are exiting their ownership positions in the company. They have achieved what they set out to do: invest in the early stage of a company and grow the equity value of their investment to the point where they can return capital to their LPs. This is a VC exit.

  We’ll go through the IPO exit more in this chapter, but we will also address another and more common type of exit: the acquisition, where another company purchases yours.

  Getting to Know You

  Before we jump in to some high-level discussion of acquisition terms and considerations, let’s walk it back a bit first. One important consideration for all startups—whether you intend to remain stand-alone or may one day seek to be acquired—is to spend time understanding who your likely eventual acquirers might be and finding ways to engage with them. This notion often sounds counterintuitive to many strong entrepreneurs. They wonder, Why would I want to tip a potential competitor or acquirer off to what I am doing by proactively reaching out to them?

  Well, it goes without saying that you don’t need to expose any of these players to your core intellectual property, trade secrets, or detailed road maps. But that being said, building relationships is important nonetheless—and you can choose to disclose whatever level of information with which you are comfortable. Even if you are not interested in an acquisition, these companies may often be good business development partners as they likely have existing sales channels into some of the markets you are planning to enter. Some of the best acquisitions often stem from relationships that begin as business development partnerships.

  Most importantly, companies get bought, not sold. That is, it’s very difficult to wake up one day and decide you want to sell your company and assume that you can just call up a bunch of potential suitors and have them champing at the bit to acquire you. Sometimes that indeed happens, but the far better strategy is to have potential acquirers solicit your interest in being acquired. When any of your potential acquirers decides it’s time for them to think about making an acquisition in your space, you want to be on the list of potential candidates. It’s a bit like the high school dance—you want to be invited to the dance (hopefully by more than one suitor), even if you ultimately decide not to go. But not receiving the invite can be painful.

  Acquisitions and Key Terms

  We’re discussing acquisitions first, because that is the predominant form of exit in the VC world. There was a time—most of the first twenty to thirty years of the history of venture capital—where exits were fairly evenly distributed between acquisitions and IPOs. But as we discussed earlier in the book, starting in the late 1990s (excepting, of course, the dot-com bubble of 1999 and 2000), the number of IPOs started to decline fairly precipitously. As a result, if you look at VC exits today, more than 80 percent come via acquisition, a far cry from the fifty-fifty split between acquisitions and IPOs that dominated most of VC history.

  Let’s cover some of the important terms that boards often consider when evaluating an acquisition offer.

  Not surprisingly, price often tops the list. But price alone is not the only thing to think about. Often the form of consideration can influence the board’s view of the price. For example, if the acquirer is proposing to exchange its shares for the shares of the acquired company, then the board will want to undertake a valuation analysis of the buyer’s shares—are they overpriced, underpriced, or fairly valued?

  To deal with the fact that it often takes time between the announcement of a transaction and the final closing, boards may ask for some price protection in the event that the acquirer’s stock price moves meaningfully in that interim period. There are various ways to do this, but a common one is to create a “collar”— essentially, you create a reasonable upper and lower bound of stock price movement and, as long as the stock stays in those bounds, the price doesn’t change, but any movements beyond that are accounted for. This is the pricing equivalent of an insurance policy; you look to cover extreme moves in either direction.

  Another aspect to consider in terms of a stock acquisition is whether the stock the acquired company receives is freely tradable. Assuming that the acquirer is a public company, one would hope that if she received stock in that company, she could sell it immediately to lock in her proceeds. Sometimes, however, if the amount of stock is material, the acquirer may not register the acquisition stock immediately, thus requiring that the recipients of its stock sit on it for some period of time. Obviously, this introduces market risk to the acquired company’s shareholders.

  Importantly to employees of the acquired company, how are employee options affected in the case of an acquisition? In particular, what if you are only two years into the vesting of your options and the company decides to sell itself? There are a number of possibilities that should be outlined in your stock option plan, so let’s go through each of them:

  Scenario 1. Your unvested options get assumed by the acquirer. This means that, if you are given the opportunity to stay with the acquirer and choose to do so, your options continue to vest on the same schedule (albeit as part of the equity of the acquirer). Seems reasonable, unless you decide this wasn’t what you signed up for, don’t want to work for the new employer, and quit. In that case, you would forfeit the opportunity to vest the remaining two years of your option grant.

  Scenario 2. Your unvested options get canceled by the acquirer and you get a new set of options with new terms (assuming of course you decide to stay with the acquirer). The theory behind this is that the acquirer wants to reincent the potential new employees or bring new employees in line with its overall compensation philosophy. Again, seems reasonable, though of course it’s a different plan than the one you originally agreed to.

  Scenario 3. Your unvested options get accelerated, meaning that they automatically become vested as if you already satisfied your remaining two years of service. We talked about this earlier in the vesting section of the term sheet and noted that there are often single- or double-trigger acceleration provisions in options granted to executives. Not surprisingly, acquirers don’t like single triggers, because they at least want the option to retain good talent without having to give them wholly new option grants. Double triggers help address the concern about single triggers (which are rare) by giving the acquirer a chance to hold on to strong talent. Still, it is very unusual for most employees to have either of the above forms of acceleration. Those are typica
lly reserved for senior executives where it’s highly likely in an acquisition scenario that they won’t or can’t be offered jobs at the acquirer—for example, you can’t have two CFOs for a single company—and thus won’t even have a chance to vest out their remaining shares.

  The broader employee issue consideration is which employees of the acquired company are considered critical to the go-forward business. Often you will have an acquirer put together a list of key employees that it wants to retain (and often as part of this there may be some material amount of financial incentive in the form of equity grants to those individuals from the acquirer) and what percentage of those employees are required to in fact come over to the acquirer as part of the deal.

  You can imagine that this sometimes creates potential holdout issues—i.e., if I know I am on that list, do I ask for some additional consideration in exchange for agreeing to join the acquirer? As such, the selling company wants to keep the required acceptance rate as low as possible, whereas the acquirer wants to get as many as possible of those whom it considers to be the key employees to come over.

  To get to the desired outcome, the acquirer will create a closing condition (meaning that it doesn’t have an obligation to close the acquisition until the condition is met) that requires some agreed-upon percentage of the key employees to have accepted their offers of employment to work at the acquirer. There is no magic number here, as it depends greatly on whether the main reason for the acquisition is to get access to the talent, or if there is a more general ongoing business that the acquirer is trying to get hold of.